Behavioral Finance Economics 437

Readings Daniel Kahneman, “Thinking: Fast and Slow” Michael Lewis, “The Undoing Project” Burton & Shaw, Chapters 8-13

Endowment Effect Knetsch and Sinden (1984): $ 2 or a lottery ticket Participants are “endowed” with either $ 2 or a lottery ticket. When offered to switch or trade, few chose to switch. Kahneman, Knetsch and Thaler (1990) Mugs and Pens

Kahneman, Knetsch and Thaler (1990) Mugs sell at Cornell bookstore for $ 6 Give every other participant a mug, let everyone examine the mugs Announce that there will be four market trials to determine the market price of the mugs, but only one trial, selected randomly, will be “binding” What does economic theory predict will be the outcome? When markets clear, mugs will be owned by those who value them the most Divide the participants into “mug lovers” and “mug haters” (in equal numbers) Since mugs were assigned at random, on average half of the mug lovers will be given a mug and half will not. This implies that half of the mugs should trade, with mug haters selling to mug lovers

Kahneman, Knetsch and Thaler (1990) -- Conclusions There were 22 mugs distributed, so the predicted number of trades was 11. In the four market trials, trades were: 4, 1, 2 and 2 Median owner was unwilling to sell for less than $ 5.25 Median buyer was unwilling to pay more than $ 2.25 to $ 2.75

Another Version of Same Experiment 77 students at Simon Fraser U were randomly assigned to three situations: Sellers, given an SFU coffee mug (then asked would they sell at prices ranging from $ .25 to $ 9.25) Buyers (then asked would they buy at prices ranging from $ .25 to $ 9.25) Choosers (then asked to choose either receiving a mug and receiving that amount of money for each price from $.25 to $ 9.25) Result: Note that sellers and choosers are in objectively identical situations Median reservations prices: Sellers $ 7.12; Choosers $ 3.12; Buyers $ 2.87 Conclusion: low volume of trade is produced mainly by owner’s reluctance to part with their ‘endowment.’

Similar Experiment: Pens vs Dollars 5 Dollars $ 4.50

Status Quo Effects Samuelson and Zeckhauser (1988) Subjects told: You inherit a large sum of money in cash. What to do, if choices are: moderate-risk company, high-risk company, treasury bills, municipal bonds Same as above except: A significant portion of your inheritance is not in cash, but instead is invested in a moderate-risk company (assuming no taxes or transaction costs) Second Experiment: new health care plans offered at Harvard (only new faculty accepted them – they were the default option for new faculty) Hartman, Doane and Woo A survey of California electric power consumers revealed two groups: those who felt they had very reliable service and those who had relatively unreliable service Each group was asked to state a preference among six combinations of service reliabilities and rates (with one combination described as the status quo) (highest reliability with full rates; lowest reliability 30 percent discount in rates) Results: Highest reliability group: 60.2 % favored status quo; 5.7% chose lowest reliability Lowest reliability group: 58.3 % favored status quo; 5.8% selected highest reliability

Loss Aversion The idea here is that an individual suffers more from a loss than he would enjoy and equal amount of a gain Losing $ 100 is more painful than Gaining $ 100 One doesn’t balance the other The loss is much more severe than the gain Thus, individuals try desperately to avert losses, even if it is irrational to do so (emotion outweighing rationality)

Two persons whose wealth is $ 5 million today Loss Aversion Implies That Your Utility is mainly about changes in wealth, not actual level of wealth Two persons whose wealth is $ 5 million today Person A was worth $ 1 million yesterday Person B was worth $ 10 million yesterday Isn’t one of these persons really, really happy and the other person really, really sad, even though there wealth is identical? So, is the “level” of wealth really the determinant of utility (happiness)

Consider Civil Litigation Mr. Jones sues Mr. Smith for $ 1 million All agree that Mr Jones has a 90% chance of winning And 10% chance of getting nothing at all Jones is offered $ 800,000 to settle

Jones Utility Function (shows risk aversion) Exp Value of Suit 0.8 1.0 Wealth (in $ millions)

Consider Civil Litigation Mr. Jones sues Mr. Smith for $ 1 million All agree that Mr Jones has a 90% chance of winning And 10% chance of getting nothing at all Smith is offered the opportunity to pay $ 800,000 and the suit will be dropped

Smith Utility Function (shows risk preference) Exp Value of Suit 0.8 1.0 Wealth (in $ millions)

Could Jones and Smith Be the Same Person? Would someone take $ 800,000 to settle, but refused to pay $ 800,000 to settle Evidence shows that people are eager to take money, but reluctant to pay to settle (rather take their chances) Why?

Answer: Loss Aversion Risk averse when contemplating gains Risk preferring when contemplating losses

Utility Function Utility Gains A reference point Losses

The End